Monthly Archives: February 2015

The Interest Rate is Not the Price of Money

This week we will explore one of the most poorly understood concepts in economics: the price of money. More specifically, what does supply and demand for money determine?

The traditional textbook view, as originally developed by John Maynard Keynes, is that supply and demand for money determines the interest rate. This simple notion lies at the heart of all modern macroeconomics. While some economists have disputed this notion, particularly those in the Austrian tradition, few have offered a sensible alternative.

The reason that Keynes’ liquidity preference theory has stood for so long is that offering a sensible alternative this theory requires an overhaul of the current microeconomic theory of price determination. In particular, if supply and demand for a good determines the price of that good, then how can supply and demand for money be incorporated in microeconomic price determination?

The key intellectual leap that needs to be made is recognizing that every price is a function of two sets of supply of demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

Price Determination Theory

The view of The Money Enigma is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy.

Price Determined by Two Sets Supply and Demand

Economists struggle with supply and demand for money because economics has not developed a sensible paradigm for the measurement of “market value”. As a result, current models of price determination present a very “one-sided” of the price determination process.

Every price is a relative expression of two market values. If the market value of one banana is three times the market value of one dollar, then the price of bananas, in dollar terms, is “three dollars”.

Supply and demand for a good determines that good’s market value. However, in order for us to calculate the price of a good, in terms of another good (such as money), we need to know the market value of that second “measurement good”. The market value of this measurement good is determined by supply and demand for that measurement good.

The “money price” of a good is determined by two sets of supply and demand: supply and demand for the good itself, and supply and demand for money.

The trick to understanding this concept is recognizing that the property of “market value” can be measured in both absolute and relative terms. All properties can be measured in absolute or relative terms. For example, the speed of a car can be measured in absolute terms (in terms of some invariable measure of speed such as “miles/hour”), or in relative terms (in terms of some other object that possesses the property of speed, for example, the car is doing twice the speed of the bus).

Market value can also be thought of in absolute or relative terms. The way we experience market value in every day life is in “price” terms. Price is a relative measure of market value. For example, “the price of the banana is three dollars” is a way of measuring the market value of bananas in terms of another good that possesses the property market value, namely “the dollar”.

However, both the banana and the dollar must possess the property of market value and we can measure the market value of each good individually in terms of an invariable measure of market value (just as the speed of the car and the bus can both be measured in terms of “miles/hour”, an invariable measure of speed).

In the diagram below, the price of Good A, in money terms, is determined by two sets of supply and demand. On the y-axis, market value is measured in absolute terms, that is to say, in terms of a theoretical and invariable measure of market value, or what one might call a “standard unit” of market value.

Price Determined by Two Sets Supply and Demand

The price of good A, in money terms, can rise for one of two basic reasons. Either, the market value of good A can rise, or the market value of money can fall. For example, if demand for money falls, then the demand curve on the right side of our diagram shifts downward and the market value of money falls. What happens to the price of good A? The price of good A, in money terms, rises. Why? Because price is a relative expression of two market values.

Let’s circle back around to our original question. What is the price of money?

This is not a straightforward question because price is a relative expression of two market values. Therefore, the first follow up question that needs to be asked is the price of money in terms of what? What is the measurement good?

We can measure the price of money in banana terms. For example, if the price of bananas in money terms is three dollars, then the price of money in banana terms is one-third banana.

Alternatively, we might measure the price of money in terms of a basket of goods. The price of the basket of goods, in money terms, is the price level. The price of money, in terms of the basket of goods, is the inverse of the price level, also commonly referred to as “the purchasing power of money”.

Therefore, we can’t say that the price of money is the price level, but we can say that the price of money is the inverse of the price level.

What we can’t say is that “the price of money is the interest rate”.

If you step back and look at the history of economics, it becomes clear why Keynes posited that supply and demand for money determines the interest rate.

Keynes was a pupil of the great Alfred Marshall, author of “Principles of Economics” (1890), a book that did more than any other to popularize the notion that the price of a good is determined by supply and demand for that good.

But Marshall’s work left one question unanswered. If supply and demand for a good determines the price of a good, then what does the supply and demand for money determine?

If you don’t recognize, as Keynes did not, that every price is, in fact, a function of two sets of supply and demand, then this leaves you looking for candidates. The only plausible candidate that Keynes could find was “the interest rate”.

Despite the fact that it should have been clear to Keynes (and all modern day economists) that the interest rate is determined by supply and demand for bonds, Keynes came up with his awkward justification of the notion that supply and demand for money determines the interest rate.

Just to be clear, it is perfectly correct to say that central bank operations can influence the interest rate. If a central bank creates money and uses it to buy bonds, then the demand curve for bonds shifts to the right and the price of bonds rises (the interest rate falls).

What is not correct is to say that since these central banking operations influence the interest rate, that supply and demand for money determines the interest rate.

The view of The Enigma Series is that every price is a function of two sets of supply and demand. Supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. We can measure the market value of money in absolute terms (in terms of our invariable measure of market value, “units of economic value”). Alternatively, we can measure the market value of money in relative terms: this is “the price of money” in terms of some other good, basket of goods or even other currency. The point is that there are multiple ways to measure the price of money, but none of them are “the interest rate”.

I would encourage all those who are interested in a critique of liquidity preference theory and an alternative view on price determination to read The Enigma Series.

Why Does Money Exist? Why Does Money Have Value?

The use of fiat currency in our modern society is so accepted that many people will go through their whole life without questioning why the dollar in their pocket has value, or for that matter, why it exists at all.

In this article, we shall seek to answer two basic questions. First, why does paper money exist? Second, why do we readily accept paper money in exchange for our goods and services?

Mainstream economics tends to answer both of these questions by referring to the role of money as a “medium of exchange”. In general terms, economists might argue that paper money exists because it forms a valuable role as a medium of exchange (barter economies are inefficient) and paper money has value because it is accepted as a medium of exchange.

While it is true that “money is a medium of exchange”, this is the wrong answer to both of the questions posited above.

The view of The Money Enigma is that fiat money exists because it is a useful financing tool for society. When governments don’t wish to pay their bills by raising more taxes or by issuing more debt, they can simply create money.

Moreover, the reason we accept fiat money in exchange for our goods and services is because, as a society, we recognize that money is a financial instrument. More specifically, fiat money represents a proportional claim on the output of our society. This is the way in which fiat money derives its value and this is the reason that fiat money can perform its functions as a medium of exchange, a store of value and a unit of account.

In simple terms, money is the equity of society. Fiat money exists because it is a useful as a financing tool and it has value because it is a financial instrument (it is a special-form equity instrument of society).

The fact that fiat money is a “medium of exchange” is incidental to its nature. More specifically, fiat money does not derive value from its nature as a medium of exchange. Rather, money can only perform its role as a medium of exchange because it possesses the property of market value, a property that is derived solely from its nature as a financial instrument.

Those that claim that money has value because it is accepted as a medium of exchange are engaging in a circular argument. Why does money have value? It has value because it is widely accepted in exchange. Why is money widely accepted in exchange? It is accepted because it has value.

The problems created by this circular argument are largely ignored by most economists, despite the fact that this circular argument lies at the heart of Keynes’ liquidity preference theory. We will discuss the flaws in liquidity preference theory another time. For now, let’s take some time to explore the two simple questions we started with.

Why does fiat money exist?

The view implied by many textbooks is that fiat money exists because it is a useful medium of exchange. But was creating a medium of exchange the motivation of those who first issued fiat money?

Let’s put that question another way. Do you think that the first kings that issued fiat money did so because they felt that their society needed another “medium of exchange”? Was fiat money just part of a benevolent desire by those rulers to assist commerce? Were these rulers visionaries who saw the long-term benefits to trade of paper money?

The short answer to all three questions is “no”.

Paper money was introduced to pay the bills when the kings ran out of gold.

The kings in our early societies didn’t create paper money because they were worried that gold wasn’t fulfilling its role as an efficient “medium of exchange”. Gold and silver were doing just fine as a medium of exchange. Rather, the issuance of paper money was an act of survival: it offered a mechanism to pay the army when the kingdom was close to running out of gold.

However, there was a trick to this arrangement. In order for this new paper money to be accepted, the king had to convince the people that the money was “as good as gold”. More specifically, the money had to be issued with the explicit agreement that it could be exchanged for a fix amount of gold on request (for example, one ounce per dollar). If people believed that this promise was credible, then the paper money would trade at the same value as its gold equivalent. However, if this promise lacked credibility, then the value of the paper money would soon collapse.

Nevertheless, in most cases, this system worked, at least for a while.

Fiat money was issued because it performed a unique role as a financing tool. If the kingdom couldn’t raise taxes and was reaching the limits of its borrowings, then issuing paper money that was backed by gold was an attractive way of financing public expenses.

The point is that fiat money is a financing tool. Originally, fiat money was issued as a financial instrument that promised the bearer a certain amount of gold or silver. This is why fiat money was accepted and why it was considered by all to possess the property of “market value”.

Over time, most modern societies have abandoned the gold standard. Most fiat money is no longer convertible into gold at request. But this hasn’t changed the reason money is issued. Money is a financing tool that. Money is still issued to pay for public activities that we, as a society, don’t wish to pay for with taxes or with the issuance of government debt.

Once you strip away all the technical language, the activities of our modern central banks are simple. When governments wish to manipulate financial markets (most notably, suppressing the interest rate by purchasing government debt), they have three basic choices to fund their debt purchases: raise taxes, issue debt or print money. Issuing debt and using the proceeds to buy back that debt defeats the purpose of the exercise. Raising taxes to buy government debt is not a popular move and is likely to be counterproductive, particularly when the economy is weak. Therefore, the government, through its monetary policy agency (the central bank), issues money to buy its debt. This action lowers the interest rate and everyone is happy.

Once again, nothing has changed. Fiat money is issued to pay for things (buying debt) that the government doesn’t wish to pay for by raising taxes or issuing debt. Fiat money exists because it is a financing tool “par excellence”.

What has changed over time is the way in which fiat money derives its value and this brings us to our second question.

Why does fiat money have value?

If we go back to our earlier example, the reason that fiat money had value in the days of the gold standard is obvious: money was backed by gold.

Gold is a real asset, which is to say that it derives its value from its physical properties.

Fiat money is not a real asset. Rather, fiat money is a financial instrument, which is to say that it derives its value from its contractual properties.

Real assets versus financial instruments

Paper money has no value in and of itself. However, paper money does represent something. In the case of early fiat money, paper money represented an explicit claim to a certain amount of gold or silver. The holder of paper money was a party to a contract that stated that the holder could exchange that piece of paper for something of more tangible value.

The mystery of paper money is why it continued to possess any value once the explicit gold convertibility feature was dropped. Why did paper money continue to have any worth once the explicit contract was rendered null and void?

Conventional wisdom is that money continued to have value because, by that time, it was accepted as a medium of exchange. The problem is that this creates the circular argument that we alluded to earlier.

Money is only accepted as a medium of exchange because it possesses the property of “market value”. If money did not have any value, then it would not function as a medium of exchange (if money had no value, you wouldn’t accept money from me in exchange for your goods/services).

If that basic fact is established, then we can’t also argue that money has value because it is accepted as a medium of exchange. Either money is a medium of exchange because it has value, or it has value because it is a medium of exchange. It can’t be both.

Therefore, what we need is something to break this circular argument. More specifically, we need a better model for explaining why fiat money possesses the property of “market value” when the explicit gold backing is removed.

As discussed, fiat money is not a real asset: it doesn’t derive value from its physical properties. Therefore, fiat money must be a financial instrument: it must derive its value from some sort of contractual arrangement.

The solution is to imagine that when the gold-convertibility feature was dropped, the explicit contract that governed fiat money was replaced by an implied-in-fact contract. In other words, when the gold-convertibility feature was removed, paper money no longer represented an explicit claim to something of value. But, it did still represent an implied claim to something of value: the output of society.

The view developed by The Enigma Series is that money is the equity of society. More specifically, money is a long-duration, proportional claim on the output of society. Money is an economic liability of society, even though it remains a legal liability of government and is issued by government on society’s behalf (society can not issue claims directly because “society” is not a legal entity).

The explicit contract that governed fiat money (gold-convertibility) was replaced by an implied-in-fact contract. This new contract, which is in essence an agreement between every member of society, states that money is a proportional claim on the output of society.

This is a complicated idea, but we can think of it in simple terms.

In essence, money is a much like a share of common stock. A business can issue common stock and each share becomes a proportional claim on the future cash flow of that business. All else remaining equal, the greater the expected future cash flows of the business, the more valuable each share is. All else remaining equal, the greater the number of shares outstanding, the less valuable each share is.

Money is an economic liability of society. Society, like a business, can issue claims against the future economic benefits it expects to generate, most notably, future economic output.

Society can issue money (print dollar bills) and each unit of money (each dollar) becomes a proportional claim on the future output of that society. All else remaining equal, the greater the expected future output of society, the more valuable each unit of money is (the greater its purchasing power). All else remaining equal, the greater the number of expected units of money on issue, the less valuable each unit of money is.

When a society is doing well and is expected to remain prosperous, the value of its money should be strong (and inflation should be contained). Conversely, if output is expected to collapse and a society is printing more and more money just to make ends meet, then the value of that proportional claim on future output is going to collapse. This second scenario is the recipe for hyperinflation.

Clearly, money is not a typical equity instrument. For example, money is a claim to a slice, not a stream, of future benefits. However, in practice this difference is relatively minor. The Velocity Enigma, the third paper in The Enigma Series, explains how we can create a valuation model for money that looks very similar to a valuation model for a share of common stock. In particular, we can use the notion of intertemporal equilibrium to create a probability distribution for the expected future benefits of money. The resulting valuation model is something that equity traders would find very familiar.

Valuation model for fiat money

In summary, fiat money exists because it is a financing tool that is too useful for our society to ignore. In order for fiat money to be able to finance spending by our society, it must offer the holder something in return. And it does. Fiat money derives its value from its contractual properties. Early fiat money derived its value from an explicit contractual property: gold-convertibility. Modern-day fiat money derives its value from its implied contractual property: it is a proportional claim on the future output of society.

Author: Gervaise Heddle

The Central Banks: Who will Save the Lifeguards?

Modern central banks are the lifeguards of our financial system. When our financial system is drowning and the economy is sinking beneath the waves, it is the central banks that must come to the rescue. But what happens when the people tasked with saving the system are out of effective options? Who will save the lifeguards when they’re drowning?

Only twenty years ago, the notion that the lifeguard of the financial system might run out of options and not be able to rescue the economy was unthinkable. The Federal Reserve, and the other major global central banks, could always cut interest rates. With interest rates in the mid or even high single digits, central banks could “slash” interest rates, thereby providing a massive boost to economic activity.

If this drastic action failed, then the central banks could use the “last resort option”: printing money. Everyone believed that printing money would have an immediate and positive effect on stabilizing financial markets and promoting full employment. In a way, they were right: QE has certainly promoted “stability”, or what others might call “speculation”, in financial markets.

However, the very real question that confronts us now is what happens in the next crisis? What tools do the central banks have left at their disposal to deal with the next crisis? And will these tools be effective at saving the markets and the economy? And if the central banks fail, then who will step up and save the economy?

At this point in time, confidence in the economic future of the United States is high. Very few of the investors that I met with recently in New York believe that any sort of serious economic disruption is coming in the immediate future (next 12-18 months). But what if it does? After all, the current environment of economic optimism is very similar to that which preceded both of the previous recessions.

What if 2015 turns out to be a year of deep recession, or worse, a year in which the global banking crisis returns? What strong, bold actions can the Fed take from here? What can the Bank of Japan do that it has not already done? What aggressive steps can any of the central banks take without risking their credibility, destroying the value of their respective currencies and driving up the price level?

The central banks have a problem. In their rush to be all things to all people, they have forgotten to prepare for their most important role. In order for the central banks to act as the lifeguard of the financial system, they must keep something in reserve. This they haven’t done.

We can think of this by way of simple analogy. When someone is drowning, a lifeguard must race out into the water, swim through the waves, get that person on their board and bring them back ashore. This is the glamorous part of being a lifeguard that we see on television reality shows.

However, the part we don’t see is just as important. The lifeguard must rest and recuperate between rescues. The lifeguard must sit and watch the developing rips and keep an eye out for those that are getting into trouble. Most importantly, the lifeguard must remember that she is a lifeguard. She can’t be down at the beach just “having a good time”.

Moreover, the lifeguard can’t be in the water with all the other swimmers when trouble comes. If the lifeguard is suddenly caught in a rip, then maybe the lifeguard can save herself, but how will she see all the other swimmers that are in trouble and be in a position to rescue them?

The problem for the major central banks is that they have spent too much time in the water (a sea of excess monetary liquidity) and are not ready for the next rescue. Despite the fact that their efforts are well intentioned, the central banks are in a very poor position to react when the next rip develops and starts to drag the weaker swimmers under.

A major part of the problem is the somewhat ridiculous multi-point mandates that the central banks have imposed upon themselves.

Officially, the Fed has three key objectives for monetary policy imposed upon it by Congress: maximum employment, stable prices, and moderate long-term interest rates. From this comes the “dual mandate” of the Fed: maximum employment and price stability.

This dual mandate has already been widely criticized, not just by those on the outside, but by those on the inside. One of the greatest central bankers of the 21st century, Paul Volcker, in his May 2013 speech to The Economic Club of New York titled “Central Banking at a Crossroad”, argued that the dual mandate of the Federal Reserve is “both operationally confusing and ultimately illusory”.

However, the responsibilities of the Federal Reserve extend far beyond this “confusing and illusory” dual mandate. In addition to maximum employment and price stability, the Fed is also tasked with supervising the banks and ensuring the stability of the financial system.

It is this last point that is perhaps the most important role of the Fed. The Fed’s role in ensuring the stability of the financial system is something that is largely taken for granted by the markets. But in its attempts to fulfill its other goals, most notably “maximum employment”, the Fed has embarked on a highly aggressive policy path that will significantly impair its ability to fulfil its most important role just at the time when it is needed most.

If the Fed was not tasked with maintaining “maximum employment”, then the Fed could have unwound QE by now and could have begun the process of normalising interest rates. If a crisis hit today, the Fed could cut rates and re-engage in unconventional policy measures such as quantitative easing. But this is not where we are. Nearly seven years since the last crisis, the Fed has not even begun the process of reducing the monetary base or raising interest rates.

So, what are our options if another crisis hits today?

Frankly, they’re not good.

The major central banks can’t cut interest rates: they’re already at zero. They could print more money. However, it’s far from clear whether the beneficial effects of this action would offset the potentially negative effects of this action. Clearly, it depends somewhat upon the nature of the crisis. If the crisis was related to some part of the private credit markets (student or auto loan defaults), then the Fed might be able to dampen the effects of the crisis by buying up these loans and the impact on inflationary expectations may be small.

However, if the crisis involved a loss of faith in the long-term economic outlook of the United States, then any actions by the central bank may be counterproductive. Ramping up the monetary base from unprecedented levels to even more unprecedented levels may not be the best solution for restoring confidence. Rather, it may be the straw that breaks the camel’s back: an act that triggers a loss of faith in fiat currency, which in turn ignites a wave of global inflation that wreaks further havoc in the global financial markets.

If the central banks can’t solve the next crisis, then who can?

Clearly, fiscal policy makers could always revert to the first (and only) recommendation in the Keynesian playbook: spend more money.

Again, this is a fine idea in the right circumstances. A country with relatively low levels of government debt to GDP can, and should, issue debt to support the economy in a time of crisis. But we don’t live in that world today. Government debt to GDP is now at levels that have only been seen in a time of war.

Once debt levels reach a certain point, taking on further debt to support the economy becomes counterproductive. Maybe we are not at that point yet. Maybe we are. The problem is that we should never be in the position where we are even contemplating crossing that line in the sand.

So the question remains. What happens in the next crisis? Who will save the lifeguard when the lifeguard is about to drown?

Price Determination in a Barter Economy

How are prices determined in an economy with no money? Let’s put that question another way. How are prices determined in a genuine barter economy where there is no commonly accepted medium of exchange?

You might think that this would be one of the first issues discussed in a standard microeconomics textbook. After all, once we can understand how prices are determined in an economy with no money, then surely we can extend this paradigm to price determination in a modern economy that does use money.

You would be wrong.

Microeconomics textbooks avoid this problem like the plague, and with good reason: mainstream economics today does not offer a sensible model of price determination in a barter economy. It is this failing to understand price determination at its most basic level (at the level of a barter economy) that has led to the one-sided perspective of price determination that is taught today.

The view of The Money Enigma is that every price is a relative expression of two market values. Moreover, every price is a function of two sets of supply and demand: supply and demand for the “primary good”, and supply and demand for the “measurement good”.

Price Determination Theory

Nowhere can this theory be more clearly illustrated than in a barter economy.

In our modern society, we take it for granted that prices are expressed in money terms. A bunch of bananas might cost $3, while a can of beans might cost $1.50. But it wasn’t always so.

Before the introduction of fiat currencies, and before the widespread use of gold and silver as a medium of exchange, prices weren’t expressed in terms of “x dollars” or “y coins of silver”. In a genuine barter economy, with no commonly accepted medium of exchange, every good would have hundreds, if not thousands, of different prices.

For example, in a genuine barter economy, the price of one apple might be measured in terms of cups of rice, handfuls of beans or a certain number of bananas. It is impossible to say what “the price of apples” is without making an explicit reference to the other good that is being traded. We can’t say the price of apples is “three”. The price of apples may be “three bananas”, but it may only be “one cup of rice”. In a barter economy, every good has a whole set of different prices reflecting the fact that its price can be measured in terms of a whole range of other goods.

So, how are all these different prices determined in a barter economy? For example, what determines the price of apples in a barter economy? A modern-day student of economics would probably answer “supply and demand for apples”. But this misses a critical point: there are many different prices for apples. For example, does supply and demand for apples determine the price of apples in banana terms or the price of apples in rice terms?

Clearly, the answer is more complicated than just “supply and demand for apples”. The correct answer is that every price is determined by two sets of supply and demand: supply and demand for the “primary good” (in this case, apples) and supply and demand for the “measurement good” (in this case, that might be bananas or rice or some other good).

The price of apples (the “primary good”) in banana terms (the “measurement good”) depends upon the market value of apples and the market value of bananas. The reason for this simple: price is a relative expression of the market value of two goods. The market value of apples is determined by supply and demand for apples. The market value of bananas is determined by supply and demand for bananas. The price of apples in banana terms is a relative expression of these two market values. Hence, the price of apples in banana terms is determined by two sets of supply and demand. This is illustrated in the diagram below.

Price Determination Barter Economy

The trick to illustrating this concept is recognizing that market value can be measured in both absolute and relative terms. In the diagram above, the market value of both goods is measured in absolute terms. In other words, the y-axis in both diagrams above uses an invariable measure of market value to measure the market value of apples on the one hand and bananas on the other hand.

Unfortunately, the measurement of market value in absolute terms is a difficult concept for most people to understand (it is a concept explored at length in The Inflation Enigma). So let’s think about price determination in a barter economy in more simple terms by answering the following two-part question. In a barter economy with no commonly accepted medium of exchange:

  1. How is the price of apples in banana terms determined?
  2. How is the price of bananas in apple terms determined?

These are both perfectly valid questions that microeconomics should be able to answer. In a barter economy, the price of every good can be expressed in terms of every other good (every good other than itself). Apples will have many prices, one of which is the price of apples in banana terms. Similarly, bananas will have many prices, one of which is the price of bananas in apple terms.

The simplistic and incomplete answers to the questions above would be:

  1. The price of apples is determined by supply and demand for apples.
  2. The price of bananas is determined by supply and demand for bananas.

Can you see what is wrong with these two answers?

The problem is that they are, in effect, different answers to the same question.

The price of apples in banana terms is merely the reciprocal of the price of bananas in apple terms. For example, if the cost of one apple is three bananas, then the cost of one banana is one third of an apple.

The answers given above suggest that one set of market forces (supply and demand for apples) determines the first price and another entirely different set of market forces (supply and demand for bananas) determines the second price. But this simply can’t be the case. Both prices must be determined by the same set of market forces because the two prices are merely different ways of saying the same thing.

So, let’s try again. What determines the price of apples in banana terms? Is it supply and demand for apples, or is it supply and demand for bananas? The answer is both. The price of apples in banana terms is determined by both supply and demand for apples, and supply and demand for bananas.

Price Determination Barter Economy

Conversely, the price of bananas in apple terms is determined by both supply and demand for bananas and supply and demand for apples. It must be because this price is merely the reciprocal of the “apples in banana terms” price. In terms of the diagram above, the price of bananas in apple terms would be denoted P(BA) which is equal to V(B) divided by V(A).

What makes this theory really interesting is that we can extend this model of price determination to a money-based economy.

Imagine that over time, bananas become accepted as the medium of exchange in our barter economy. Suddenly, we can speak of the value of all things in “banana terms”. Does the adoption of a medium of exchange change the way that prices are determined? No. The price of apples, in banana terms, is still determined by supply and demand for apples, and supply and demand for bananas. All that has happened is that bananas are now “money” (at least in one sense of that term).

The implication of this is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. This is true whether money is bananas, gold or the fiat currency that we use today.

As a consequence, we can say that the price of apples, in money terms, is determined by both supply and demand for apples and supply and demand for money. This is illustrated in the diagram below.

Price Determined by Two Sets Supply and Demand

Price determination in a barter economy is an important subject. If the great minds of economics had spent more time thinking about price determination in a barter economy (rather than buying into the myth that is Keynes’ liquidity preference theory), then I believe that we would have a far better understanding of price determination and inflation than we do today.